A Theory of Financial Liberalisation: Why are Developing Countries so Reluctant?

Abstract

This study treats capital flows as risky growth opportunities for both investing and host countries in a standard mean‐variance model. Differing optimal trade‐offs between growth and volatility on both sides of capital flows are examined on the basis of their different attitudes towards destabilising risk, different considerations of capital market openness and different levels of financial sector development. It is established that growth and volatility may have a positive or negative relationship in theory, but in practice, they are correlated negatively with each other. This negative correlation is significantly non‐linear after some normalisation and holds persistently not only for developing but also for developed countries. The study shows that one side’s push for financial liberalisation may come across the other side’s resistance to it. This conflict of interest can be resolved via negotiations for a compromise equilibrium at which both sides’ optimal trade‐offs are made internationally compatible.